Price Discovery
Investment securities may be sold to institutions or to individuals and sold in public or private offerings. Companies with certain profiles can raise significant financing by public offerings. The amount of money raised depends on the unit price of the securities sold and the number of units sold. One example of a securities offering is an initial public offering (IPO). In an IPO there has been no prior public market for the securities that would establish a price-demand curve for the securities. This makes pricing of securities difficult in an IPO. However, also for other kinds of offerings, investors may be uncertain about an appropriate price offer, and the offering party may need information about demand and appropriate pricing.
Generally, the offeror selects a lead underwriter for the offering and that underwriter uses a variety of methods to develop information on possible demand for the securities, so that a price can be established. The underwriter must contact potential buyers and work with them to determine the price (if any) they are willing to pay for the to-be-offered securities. With sufficient firm bids in hand, the underwriter can then sell the securities, making allocation decisions as needed, if the bids exceed the amount of securities offered.
In public securities offerings, a lead underwriter (book-runner) manages and coordinates the entire process of a securities distribution and has sole access to an aggregated “book” of bids as well as the discretion to allocate securities to bona fide investors. There are several possible methods a book-runner can utilize to price and distribute securities; however, the “book-building” methods is that most frequently utilized with the “dutch auction” method being utilized on occasion. Both methods serve as a final means to collect, aggregate and calculate a final price and allocate shares. On rare occasions, a lottery is held by a specific underwriter during an oversubscribed transaction to allocate a portion of shares for retail/individual investors.
During the course of the securities registration period, the issuer (the company offering the stock) and the underwriters may mutually agree to change the proposed price range or amount offered in response to: (1) inferred market conditions' impact on potential demand and pricing; (2) feedback the lead manager receives from its syndicate's respective distribution network of salespeople and brokers; or (3) specific issuer demands or objectives.
The conventional price discovery methods have limitations affecting both investors and underwriters, for several reasons. The methods lack transparency. That is, investors have no opportunity to review the aggregated source bid data or the rationale upon which final pricing its based by the book-runner. Further, there are barriers inhibiting pricing feedback between the offering syndicate and the investing community, so that communication of pricing information is not truly real-time. The issuer and its bankers are traveling on a “roadshow,” often globally, to meet potential investors, which can exacerbate timing lags in communication and decision making. During the course of the roadshow there are many layers of communications among the syndicate, their respective distribution networks, and potential investors, each of which can create a timing lag, as well as potential for miscommunication.
Another limitation on communication is created by SEC regulations. SEC regulations strictly limit the information a broker/dealer involved in a securities distribution may provide—the information is limited to the delivery of a prospectus. Thus, by law, underwriters may not show investors any other data, no matter how valuable the market might deem it, lest such information be deemed a prospectus subject to SEC review. Trying to provide the marketplace with additional information beyond a traditional prospectus creates an unworkable paradox because of the regulations placed on the broker/dealer community. Providing the data would require adjusting the prospectus, which would take time. During such time lag and as a result of data change, the market could change again. Thus, no market equilibrium is reached, and with multiple adjustments the final pricing could theoretically be delayed substantially. This can hurt the issuer, underwriter and the efficiency of the capital markets. Depending on the security and type of registration document that the issuer utilizes, SEC regulations may also require that if the total dollar amount raised based on the final pricing is increased or decreased by greater than 20% of the latest prospectus filing amount, the issuer must file an amended registration statement with the new amounts and wait 48 hours for effectiveness of such amended registration statement. Facing such a time delay forces underwriters and issuers to determine the costs and benefits of filing such an amendment.
One suggested alternative for developing pricing for an offering is to sell the securities in some form of open auction, where the public can submit bids. The shares can be allocated by rules stated to the bidders by the underwriter that manages the auction. Such a public auction is described in U.S. Pat. No. 6,629,082. That patent discusses allocation rules defined by economist William Vickrey.
Pricing and Allocation of Demand
The “book-build” and “dutch auction” processes have a similar underlying objective to aggregate and qualify all demand (excluding non bona fide or outlying bids) and create a clearing price. In both processes, the underwriters canvass demand of investors via a roadshow, placing primary emphasis on large institutional buyers who have the experience and resources to evaluate a company and determine valuation for securities of an issuer. The two methods vary, however, in their determination of what constitutes the clearing price and in allocation of demand.
In the “book-build” process, underwriters receive indications of interest that are forwarded to the book-runner, who compiles a list of bona fide potential investors, the security amounts they desire and price level or limitations. The book-runner generally has total discretion to allocate shares and to move the price within the allowable range. Once satisfied with the process, the book-runner proposes to the Issuer final prices and terms, as well as a “book” of investors recommended to receive an allocation. Typically there is room for the issuer to negotiate several items such as price and preferred investors. Once an underwriting agreement is executed, the orders from investors are confirmed (investors may also cancel their order up to this time for any reason including if the terms, conditions, or price have been varied as a result of negotiations between the book-runner and issuer).
Inherent in the book-build process is an estimation of the discount (if any) required to attract investors to a new issuer (versus other similar public comparables). This discount then forms the basis for the so-called aftermarket “pop,” or value increase A “pop” enables the transaction to be perceived as a success in the investment community, compensates investors (mostly institutional) for taking a risk on a new issuance of a security, and reduces the odds that the underwriters will be left holding the security. This could happen if investors failed to pay for their allocation, because the security traded immediately below its issue price. Alternatively, a disproportionately large “pop” often means there was large unfilled demand. Such underpricing may deprive the issuer of useful incremental capital. Instead such profits flow to the secondary markets (for example, investors and traders).
In the “dutch auction” process, bidders are qualified by the lead manager to participate and receive a bidder identification number. When the bidding period opens, investors may submit one or more bids of varying amounts. Bids may be modified while the auction is open; however, they become final at a specific timeframe, and the transaction is priced. To determine a clearing price, bids are aggregated by price from highest to lowest, and by summing shares bid until the supply (the number of shares the company desires to sell) is met. The dutch auction manager reserves the right to eliminate bids it considers manipulative (excessively high or large bids). The price per share of the lowest bid that fulfills the supply available is the price that all investors in a dutch auction IPO receive on their investment. The dutch auction considers the individual's bid equally alongside an institutional bid without regard to number of shares bid.
Challenges of Historical Price Discovery and Allocation Process:
The Book Build Process
The book-build and, more recently, the dutch auction processes have successfully matched trillions of capital of investors to issuers over the history of the public U.S. capital markets. The depth and fluidity of U.S. capital markets exceed any other in the world; however, recent regulatory action against, and large financial settlements by numerous broker/dealers with regard to underwriter research, IPO pricing, securities allocation, and aftermarket trading commissions provides the moment to consider novel approaches for the U.S. to further improve its capital markets.
These regulatory actions sought to inject more transparency into price discovery and greater allocation fairness into the capital raising systems. A reason for the lack of transparency lies in the price discovery and allocation process resting solely with the book-runner. The book-runner must mitigate the risk of conflicts of interest inherent in having two clients, one on each side of the transaction, i.e., the investor and broker/salesperson v. the issuer and the corporate finance banker. In addition, the book-runner has obligations to its own representatives.
The book-build process has inherent limitations. For price discovery, the book-build process is dependent on human interaction between the book-runner's distribution network and syndicate and the investment community. As a result, it is subject to time-lags, miscommunication and disinformation.
Time-lags occur, because the entire distribution system and syndicate must canvass demand, primarily in the oral format, and then take the time to convert the raw data into useful computer-based analytical materials. Time-lags and inefficiency of information collection also arise because the syndicate suffers the same vagaries of human interaction that exist in a typical vendor/customer relationship. A given salesperson/broker may not have a strong enough relationship with his/her customer to elicit timely feedback, or may decline to make further follow-up calls requested by the book-runner on any specific securities transaction in the short-term, for fear of upsetting the long-term customer relationship.
Miscommunication can result from simple verbal or body language miscues, interpretive mistakes in converting oral instructions to written, or a misunderstanding by the broker/salesperson or customer of the issuer or its proposed transaction terms and conditions. Such miscommunications increase the risk of erroneous data being factored into the pricing.
Disinformation results from investor tactics employed to offset the asymmetric information balance between any one investor and the book-runner, who is the only entity with full access to all investor bids and the Issuer's objectives. The largest investors are heavily courted during a securities transaction as a result of their collective buying power and knowledge of securities valuation. As a result, they know their inputs are valuable to the book-runner as well as to other potential investors. The buyer's desire for the lowest possible price for the investment can result in disinformation tactics in the early stages of a securities transaction. Customers often worry that conveying or “exposing” their true bid price level (and knowledge) early to a broker/salesperson may result in higher pricing, and/or could be shared with other customers during the canvassing of demand (as a result of the oral-based nature of the book-build process). These tactics often lead to a rush of bids and price changes at the end of the process—such a change in price or demand can catch a book-runner unprepared. If the change is large enough, the issuer may need to file an amendment to its registration statement to capture the increase in demand or pricing (also creating a time-lag), or accept that such unfulfilled demand and price flexibility from customers will result in potentially lower proceeds than justified and an excessive aftermarket “pop.”
Another limitation of the book-build process lies in allocations. The book-runner has sole discretion to accept orders and to allocate shares (though generally the book-runner takes issuer preferences into account to the degree that a reasonable transaction may still be executed). The book-runner often prioritizes and maximizes allocations to customers who are considered knowledgeable about the issuer's sector and who have a history of maintaining reasonable holding periods for securities purchases via a new issue (i.e., they are not short-term “flippers” who immediately, or a short time thereafter, trade a security back to the syndicate to collect a profit or limit a loss). An investor desires to obtain an allocation reflective of its view on that issuer's sector and commensurate with the customer's overall portfolio size.
Other general securities underwriting challenges include allocation issues where it is frequently difficult for a small investor to obtain shares of a “hot” issue, and pricing quandaries based on the tradition that the underwriting process is a closed process where only the underwriters know the demand price and overall interest level in a given offer (i.e. asymmetric information) and there is no real-time feedback to investors about their bid price or potential allocation before the auction closes, which permit them to refine their bid to the benefit of all parties.
The Dutch Auction Process
Offering processes, such as “Open IPO” processes, where the offering price is determined via a “dutch auction” methodology have recently been introduced (See U.S. Pat. No. 6,629,082 mentioned above.). In such process, the price at which the company sells shares to the public is based upon actual bids from institutional and individual retail investors. The offering price is determined by sorting all of the bids from high price per share to low price per share, and summing shares bid until the supply (the number of shares the company desires to sell) is met. The price per share of that bid that fulfills the supply available is the price that all investors in a dutch auction securities offering receive to make their investment. This approach improves price discovery relative to the book-build process and places institutions and retail investors on more equal footing.
The offerings built on the dutch auction process have several limitations. While more fair and democratic to a broader spectrum of investors than a book-build offering in the sense that those at or above the clearing price receive allocations irrespective of their investment “pedigree”, the open offering process is not necessarily more “open” or transparent to all participants. Firstly, the underwriters may choose to prohibit participation of certain parties based on their own review and qualification criteria so it is not truly open to all bidders. Secondarily, because the bids for an open offering are only known to the underwriters (again the asymmetric information quandary), it is impossible for bidders or potential bidders to know whether their bid is likely high enough to purchase shares until after the auction process is completed, thus there is no more transparency in a dutch auction than a book-build. Experience with dutch auctions for securities underwriting has shown that there may be completely different demand curves for retail and institutional investors. For example, in an IPO, retail investors may get caught up in the frenzy of an IPO and overbid for the offering.
While there is some protection from overbidding—if an investor bids $100 per share and the security is priced at $20 per share, all investors are charged $20 per share—this protection is not absolute. If many investors bid irrational prices in an attempt to guarantee participation in an offering, the result may be artificially to drive up the price of the offering beyond the true market price (commonly known as the “winner's curse”). Thus, all investors may lose money if the price subsequently drops. Further, in some dutch auction securities offerings, underwriters have the right to disqualify bids that are deemed to be “manipulative” by the underwriters. The rules to determine what constitutes “manipulative” are typically not defined to the public and an investor bidding too high may find itself disqualified from the offering.
There is no mechanism for participants in advance to review the demand curve of the open offering to determine whether their bid level is likely to be viewed as manipulative. For example, a participant might want to know that their bid is more than a certain amount higher (for example 3 standard deviations) than the mean bid and thus likely to be discarded.
There is also no mechanism for participants in a dutch auction securities offering to understand the effect on their bid if the underwriter decides to lower the offering price to a level below what the statistics of the securities offering would otherwise indicate (e.g., will the underwriters price the securities at 5%, 10%, or 20% below the auction-based price level). There are issues for institutional investors with regard to maintaining an optimal investment position size for any given issuer in their portfolio. Thus if the institutional investor were to receive too small of an allocation due to a unilateral clearing price reduction by the underwriter and/or issuer, the institutional investor would either need to purchase more shares in the aftermarket or would consider “flipping” their sub-optimal sized allocation back to the syndicate—creating an unattractive dilemma for either underwriter or investor.
Further, conflicts of interest arise among underwriters with retail distribution networks (i.e. individual investors) in a dutch auction securities offering. There is difficulty in determining how to protect the privacy of a broker's accounts while qualifying such retail investors. The traditional book-build process for retail distribution is opaque from each underwriter's point-of-view, as the specific retail customers' identities are kept confidential from any other broker/dealer involved in the offering. In a book-build process, co-managers and syndicate members of the offering, who plan to sell the securities (collectively, the “selling group”) are given an allocation of priced shares that may or may not correspond to their retail network's aggregate demand. These priced securities are then allocated at the discretion of that specific underwriter (or, more rarely, on a “first-come first-serve” or lottery basis) to their individual retail clients. In the dutch auction securities offering process, the trade-off for a more democratic and fair process for the smaller investor is that the broker/dealer must allow his customer to be reviewed and qualified by another underwriter who may become a competitor for that very customer relationship. This creates concerns of privacy among underwriters, because one underwriter may not want to share the bid data and the qualifications of a list or particular investor. The one underwriter will not want the lead underwriter to be able to see the demographics or even possibly names and addresses of that underwriter's account base.
Price Discovery Via User Simulations to Attain a Collaborative Forecast
The Internet provides access to financial and news information. Applications such as eBay provide marketplaces where buyers and sellers converge to determine “fair” prices for products via the dynamics of many participants in the market. Currently there is no equivalent for transparently developing the fair price of financial securities to be issued in an underwritten offering.
Generally, the public cannot acquire objective research regarding the offered security until they have already purchased the security. Traditionally, investors in offerings base their decisions on the S-1 filings with the SEC. At a set time after the offering closes (the “quiet period”), research reports from financial analysts working for underwriting companies often become available to customers of those underwriters. While these analysts evaluate the financial performance, business plans, and competitive landscape of companies, because the formal research reports are not available until after the public offering and those research reports are written by firms that were compensated to complete the offering, this practice has raised concerns regarding the independence, objectivity and value of such research.
Investors can find copious amounts of general news and information related to an upcoming public securities transaction via websites like Yahoo!, Reuters, or Google. However, there is a dearth of public websites that provide indepth information and tools relevant to a detailed analysis of a transaction. One website called EconomicInvestor (www.c4cast.com), with a patented process (U.S. Pat. No. 6,606,615), provides Bayesian analyses of participant input on various predictions, including value of stocks indexes and individual stocks with recognition for winners. Such data is applied to study how assets and portfolios respond to key economic factors.
Specifically catering to IPOs there are broad based web sites such as IPO Financial Network, or IPOHome.com; temporary niche sites such as googleiposwami.com, goggle-ipo.com; sites such as Iowa Electronic Markets which act like a derivative or futures market to establish a price for a security; or online offshore gaming sites such as tradesports.com which allow wagering on IPO outcomes. Finally price discovery logic has been applied solely for entertainment purposes to showcase a customer's stock trading (virtualstockexchange.com), or successful movie picking (Hollywood Stock Exchange) prowess. Many of these sites have polls that enable participants to vote on what they believe the results of an upcoming event will be, create model portfolios and compare their portfolio's performance to that of other participants, or even place monetary bids based upon whether an offering will exceed a particular value. However, voting and online offshore gaming are less likely to produce useful information about interest level and pricing on an upcoming offering. Voting is not effective for a securities offering as small and large investors carry the same weight which can be misleading given the different bid sizes that occur in an offering versus the vote. Furthermore the polling sites generally allow users to vote for free. Lack of financial risk and strict dependence on user trustworthiness are significant weaknesses—there is no penalty for being wrong or misleading. Online offshore gaming does not provide transparency between institutional and individual investors, and is not legal in the U.S. Neither system is appropriate to provide the relevant feedback and analysis for a securities offering and likely provide inaccurate or suspicious results. Thus, participants may place irrational wagers such as, selecting volatile stock options or “voting” a very high or low value for an upcoming IPO, because there is no financial deterrent to a participant for placing wild guesses as to the securities pricing or post-IPO market performance given the “all-or-none” nature of those types of data collection systems. The absence of realistic participation rules means that participant behavior and, thus, the process results lack realism.
Applications such as Hollywood Stock Exchange or the Iowa Electronic Markets can provide some value, but most are structured as contracts that pay a certain amount if a price threshold of the event is reached and nothing otherwise. If participants utilize real money for these methods, these “markets” may provide information of more value. However, there is considerable information missing from the results produced in such systems. For example, it is not possible to differentiate between the demand curves for institutional investors and for retail investors. Each group may have substantially different risk-reward profiles and amounts of capital to invest. Also, such simulations do not offer simulation participants a full range of bid sizes. For example, Iowa Electronic Markets have an account limit of $500 invested per participant. Thus, there is no means for an institution to simulate the results of a $20 million bid in a large public offering. There is also question of whether a derivative market can legally exist to provide true futures contracts for IPOs—SEC rules prohibit a whole series of so-called “when-issued” gray markets, as well as restrict the ability to borrow/rehypothecate stock, or short an IPO before the end of the quiet period which is approximately 25 days after the IPO.